Capital Gains on Equity & Mutual Funds

TL;DR

LTCG exemption under Section 112A, STT requirement, and how to handle segregated portfolios and switches.

Capital gains on equity mutual funds are among the most tax-efficient investment returns available in India — but the rules around how gains are calculated, which gains are taxed, and how losses can be used to offset gains are complex enough that many investors overpay tax or miss valid tax optimizations. This guide covers the complete tax treatment.

What Qualifies as an Equity-Oriented Mutual Fund

For the preferential tax treatment to apply, the mutual fund must be an “equity-oriented fund” as defined under the Income Tax Act:

Definition: An equity-oriented fund is a mutual fund where:

• At least 90% of the fund’s investments are in equity shares of domestic companies (as measured by the average of the fund’s total investments on a quarterly basis), AND
• The fund has been notified by the Central Government as an equity-oriented fund

This is important: not all funds that call themselves “equity funds” qualify. Index funds, sectoral funds, and large-cap funds typically qualify as equity-oriented. Debt funds, liquid funds, and hybrid funds with less than 65% equity do not.

Debt Hybrid Funds: A hybrid fund with 65% or more equity is taxed as an equity fund for LTCG (long-term capital gains) purposes but as a debt fund for STCG (short-term capital gains) purposes.

Short-Term Capital Gains (STCG)

When: Equity funds held for 12 months or less.

Tax Rate: 20% on gains.

How Calculated: STCG = (Sale price per unit × Number of units sold) − (Purchase price per unit × Number of units sold) − (Expenses directly related to sale)

Example: You buy 1,000 units at ₹100 each = ₹1,00,000. Sell 1,000 units at ₹120 each = ₹1,20,000. STCG = ₹20,000. Tax at 20% = ₹4,000.

STT Requirement: Securities Transaction Tax (STT) must have been paid on both the purchase and sale of the units for the equity fund taxation rules to apply. If STT was not paid (e.g., units purchased directly without going through a stock exchange), the gains are taxed as normal income at your slab rate.

Long-Term Capital Gains (LTCG)

When: Equity funds held for more than 12 months.

Tax Rate: 12.5% on gains exceeding ₹1.25 lakhs per financial year.

Cost Inflation Index (CII): For LTCG calculation, the purchase cost is indexed using the Cost Inflation Index to account for inflation. This reduces the taxable gain.

CII for Recent Years:

Financial Year	CII
FY 2017-18	272
FY 2018-19	280
FY 2019-20	289
FY 2020-21	301
FY 2021-22	317
FY 2022-23	331
FY 2023-24	348
FY 2024-25	363

Example with Indexation: Purchase 1,000 units in FY 2021-22 at ₹100 each = ₹1,00,000. CII FY 2021-22: 317. CII FY 2024-25: 363. Indexed cost = ₹1,00,000 × (363/317) = ₹1,14,510. Sell in FY 2024-25 at ₹120 per unit = ₹1,20,000. LTCG = ₹1,20,000 − ₹1,14,510 = ₹5,490. LTCG tax = 12.5% × ₹5,490 = ₹686.

Note: If you are selling units where the total gain in the FY is less than ₹1.25 lakhs, no LTCG tax is payable — even though the gain is a long-term capital gain.

The ₹1.25 Lakh Exemption — How It Works

Every financial year, the first ₹1.25 lakhs of LTCG from equity mutual funds is exempt from tax. This is a cumulative exemption across all equity fund redemptions in the financial year.

Example:

• LTCG from Fund A: ₹80,000 (no tax)
• LTCG from Fund B: ₹70,000 (no tax)
• Total LTCG: ₹1,50,000. Tax payable on ₹25,000 (₹1,50,000 − ₹1,25,000) at 12.5% = ₹3,125.

The exemption is not per fund — it is total LTCG across all equity-oriented mutual funds in a financial year.

Set-Off Rules

Set-Off Within Equity Funds

LTCG can only be set off against:

• LTCG from equity funds (same asset class)
• LTCG from equity-oriented mutual funds
• LTCG from listed equity shares

STCG can be set off against:

• STCG from equity funds
• STCG from equity shares
• LTCG from equity funds
• Any capital gain (there are no restrictions on STCG set-off)

Carry Forward of Losses

LTCG Loss: LTCG loss from equity funds can be carried forward for 8 assessment years and set off against future LTCG from equity funds or listed equity shares. It cannot be set off against STCG or debt fund gains.

STCG Loss: STCG loss can be set off against any capital gain in the same year — STCG or LTCG, equity or debt. If not fully set off, it can be carried forward for 8 years.

Important: To carry forward capital losses (either LTCG or STCG), the ITR for the year in which the loss occurred must be filed before the due date. Losses from equity funds cannot be carried forward if the return was filed late.

Segregated Portfolio (Capital Gains Segregation)

When a mutual fund creates a segregated portfolio (often due to a credit event like a debt default), the original units and the segregated units are treated differently for tax purposes.

Tax Treatment of Segregated Portfolio:

• The original units continue to be taxed as before
• The additional units received from segregation are treated as a separate acquisition
• The cost of acquisition of segregated units is treated as zero (or a nominal value) at the time of segregation — meaning any future redemption will result in the entire redemption value being treated as capital gains
• This is unfavourable for investors — the tax on the segregated units is higher because there is no cost basis

Investor Caution: When a mutual fund creates a segregated portfolio, the NAV of the original units drops, and the investor receives additional units in the segregated portfolio. The tax treatment treats the segregated units as having zero cost — so any redemption of those units results in full capital gains tax. Many investors are unaware of this and face unexpected tax bills when they redeem segregated units.

Equity Fund to Equity Fund Switch

When you switch from one equity fund to another within the same mutual fund house or different houses, it is treated as:

• Redemption of the first fund (triggering capital gains tax)
• Purchase of the new fund (starting a new cost basis and holding period)

A switch is not tax-free. The capital gains from the redeemed fund must be taxed accordingly. Only an systematic transfer plan (STP) within the same fund house between equity and debt funds may have different treatment — consult your tax advisor.

How to Report Equity Fund Gains in ITR

For STCG: Report in Schedule SP (Short Term Capital Gains) of ITR-2. The STCG is taxed at 20% after indexation (if applicable). For non-STT transactions, gains are taxed at slab rates.

For LTCG: Report in Schedule CG (Long Term Capital Gains) of ITR-2. The first ₹1.25 lakh is exempt. The balance is taxed at 12.5%.

Form 13C (Capital Gains Statement): For significant capital gains, the income tax department may ask for a detailed computation of gains — including the purchase date, purchase price, sale date, sale price, STT paid, and calculation of gains.

Tax-Efficient Strategies for Equity Fund Investors

1. Use the ₹1.25 Lakh Exemption Wisely: If your total LTCG for the year is expected to exceed ₹1.25 lakhs, consider spreading redemptions across financial years to stay within the exemption limit each year.

2. Tax-Loss Harvesting: If you have unrealized losses in some equity funds, you can redeem the loss-making funds to realize the loss and immediately reinvest in a similar fund (not the same fund within 30 days to avoid the wash-sale rule under Section 94(8)). The realized loss can offset other capital gains.

3. Hold Beyond 12 Months for LTCG: The LTCG tax rate of 12.5% (on gains above ₹1.25 lakhs) is significantly lower than the STCG rate of 20%. Holding for more than 12 months is almost always more tax-efficient.

4. Avoid Segregated Portfolio Funds Unless Necessary: Be cautious of debt funds that have segregated portfolios — the tax treatment of segregated units is unfavorable. If you are invested in a fund that creates a segregated portfolio, consult your tax advisor on the best course of action.

5. Beware of the 30-Day Rule: If you sell equity fund units and buy the same or similar fund within 30 days before or after the sale, the loss from the sale is disallowed under Section 94(8). This is the “wash-sale” rule for equity funds.

6. ELSS as an Alternative to Equity Funds: ELSS (Equity-Linked Savings Scheme) funds are equity-oriented mutual funds with a 3-year lock-in. They offer the same tax treatment as equity funds but with the additional benefit of Section 80C deduction of up to ₹1.5 lakhs. The 3-year lock-in is a disadvantage but ensures long-term holding.